Land Down Under faces Europe-style downturn

Commentary: Australia’s commodities boom nears a bitter end

By

SatyajitDas

SYDNEY (MarketWatch) — Australian equities, especially commodity producers and banks, high-yielding bonds and appreciating Australian dollar (A$) all made the country an attractive destination for investors.

But Australia’s economic outlook is deteriorating. The commodity boom, predicted to go on forever, is slowing sharply.

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Australia has been enjoying strong, consistent economic growth, low unemployment and increasing living standards. It benefitted from the increasing wealth of emerging nations, especially China and India, and demand for commodities.

Meanwhile, government spending, lower interest rates and a credit-fueled investment boom in China helped Australia avoid the worst of the economic slowdown in developed markets.

But now economic growth in China, India and other emerging markets is slowing. Even if growth levels remain above that of developed markets, the changing composition of growth (a rebalancing from investment to consumption) reduces demand for commodities. Increased capacity — the result of aggressive recent investment — will also come on-stream progressively, concurrent with lower demand.

Austere Australia

These factors place pressure on both commodity prices and exports. It will also drive a slowdown in mining investment — the linchpin of Australia’s growth. Many miners, especially mid-sized and small firms, will have difficulty raising needed equity and debt due to the weakened conditions.

Plus, excessive investment and cost overruns have created overpriced projects. That will hamper Australian resource competitiveness and financial performance. These problems may flow through into the financial institutions that have funded these projects.

The outlook for the Australian dollar is also uncertain. Dollar strength reflected higher (until recently) commodity prices. It also reflected the Australian dollar’s role as an investment proxy for China and safe-haven status as one of the few remaining triple-A-rated countries. High Australian dollar interest rates relative to other developed countries drove the “risk-on” or carry trade. Investors borrowed in U.S. dollars, yen or euro to purchase higher-yielding currencies leading to strong capital inflows.

While beneficial to international investors, the strong Australian dollar reduced the country’s competitiveness in manufacturing, retail, tourism and exports of education and health services, which are all major employers.

As strong growth in the commodity sector no longer offsets weak domestic conditions, government finances — both national and state — are deteriorating. Federal government revenues have dwindled, with cash receipts running below expectations. This reflects a slowing economy, which has translated into lower-than-expected corporate tax revenues. The government has admitted that its politically motivated budget surplus target is likely to be missed.

Weakened foundation

Australia’s external account is also a concern. Despite the mining boom, Australia’s trade account has been negative in recent years. Since 2001, the trade account has averaged a deficit of around A$500 million per month, fluctuating between a surplus of A$3.4 billion and deficit of A$3.2 billion.

In aggregate, the trade account has been in deficit by around A$68 billion or around 6% of Australia’s current Gross Domestic Product. The performance is disappointing given the record terms of trade and strong export volumes, despite the need to import capital goods associated with mining development.

Currently, Australia’s current account deficit is around A$50 billion or 3.7% of GDP. It is likely to increase to around 5%-6% of GDP based on Australia’s weaker export performance, one of the highest in the developed world. This will increase the country’s reliance on international financing.

Australian policymakers are now “rebalancing”. The Reserve Bank of Australia (“RBA”), the nation’s central bank, has cut interest rates. Lower interest rates are targeted at boosting domestic housing and consumption activity and reducing the value of the Australian dollar. The RBA has lowered interest rates by 1.75% per annum, with further cuts likely in 2014.

But with fiscal policy politically constrained, increasing pressure on the external account, decreasing effectiveness of monetary policy and attempts at competitive devaluation by major economies, Australia’s policy options are now limited.

In a November 2010 speech entitled “The Challenge of Prosperity,” RBA Governor sought to illustrate the combined effects of the gains of the appreciating terms of trade position and the Australian dollar’s strength in the following terms: “In 2005 a shipload of iron ore was worth the same as around 2,200 flat screen televisions In 2010, the same shipload was worth around 22,000 flat screen TVs.”

In a Freudian slip, the RBA Governor identified a fundamental issue with Australia’s economic model: Australia may have substantially wasted the proceeds of its mineral booms, with the proceeds channeled into consumption. The nation did not commit enough into strategic long-term investments or a new industrial base.

The mining boom helped maintain income and buying power, as Australia extracted large rewards for its mineral resources. The flood of cash covered up Australia’s lack of international competitiveness in many sectors — driven by high costs, poor productivity performance, declining educational achievements and a narrow industrial base.

Policymakers talk about the need for structural changes. But improvements in Australian competitiveness without declining living standards present challenges. Australian minimum wages are around A$16 an hour. In comparison, the minimum wage is around A$8 an hour in the U.S. and A$1-$2 per hour in China.

In an interview last December with the Australian Financial Review, the RBA Governor addressed the issue of where growth would come from to replace mining investment: “I think we always get this question: ‘Where will the growth come from?’ And most of the time it comes.”

Australian policymakers appear to have embraced the Dickensian economics of hopeful expectations where Mr. Micawber asserted his faith that “something will turn up”.

Meanwhile, international investors may direct their energies elsewhere.

Satyajit Das is a former banker and author of “Extreme Money” and “Traders, Guns & Money”

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